For 40 Years, Small Caps Still Safest Bet in Stocks

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Investors looking for both safety and return over the past 40 years of market turmoil were treated best not by the stalwarts of big business but by their much smaller brethren, research released Tuesday shows.

Using various metrics that measure the likelihood of negative returns over various time periods, small caps—or those with market capitalization rates below $2 billion—outperformed every other asset class since 1970, according to a research note from Richard Bernstein, chief investment strategist at Bank of America Securities-Merrill Lynch.

"Regardless of time horizon, small stocks offered the best risk/reward potential to investors, while gold offered the worst," Bernstein wrote.

While it won't surprise many investors to hear that small caps have outperformed the market, the knock on the group has been that those profits also come with considerable volatility due to the higher failure rate of small businesses. But Bernstein's findings show a high amount of safety among the group as well.

"It's definitely where you want to be when you have a long-term horizon," said Adriana Posada, portfolio manager of the American Beacon Small Cap Value Fund. "But it tends to be a pretty rough ride."

In addition to the findings about smaller companies, the research also shed light that will be welcome to the buy-and-hold crowd: Over any given 10-year period, the chance for investors to lose money was minimal.

"With the exception of gold, investors had little chance of losing money in our selected asset classes over ten-year time periods," Bernstein said. "Only in the current bear market did many equity benchmarks generate their first trailing 10-year losses for the periods we analyzed."

He did add caution about the strategy: The chances to lose money over long periods actually increased with technology, telecomm and utilities.

Gold also has been a difficult area in which to invest.

The metal has been a popular play in this decade and its two bear markets that investors have had to navigate, but vacillated in the previous 30 years. Similarly, the large-cap companies, with market capitalizations above $10 billion, have grown in disfavor as real returns on the major indexes have been hammered.

The Standard & Poor's 500 has seen negative 12-month returns 42 percent of the time since 2000. That stands in stark contrast to the 1970s and '80s, when the S&P had only a 1 percent chance of turning in a negative 12-month return. Since 2000, the Russell 2000 small-cap index has lost 22 percent, but small-caps overall have proven to be less risky.

"As attractive as large caps stocks were in the 1990s is as unattractive as they have been so far during the 2000s," Bernstein wrote. "Gold has so far won the performance derby despite being off more than 10% from its March 2008 high."

Posada's American Beacon fund (OTC Funds: AVPAX) has outperformed the small-cap benchmark by 2 percentage points, she said, but is off about 24 percent for 2009, reflecting troubles in the broader market.

Still, she thinks investors are best off in small caps when the economy turns, reasoning that the group can turn easiest and historically has been the first hit during a recession and the first to recover on the way out.

"They lead the way out of recession and in a big way, and that's when you get a lot of that excess performance," Posada said.

That trend has portfolio managers buying small caps, but not with abandon.

Some worry that the group will struggle if banks don't recover and begin lending again. Smaller businesses are especially dependent on access to borrowing since they don't have as easy a time raising capital as their larger counterparts.

"In an environment where banks are more willing to lend and interest rates are very low ... small caps generally perform pretty well. My only concern in this go-round is are we going to see those two dynamics in place," said David Twibell, president of wealth management for Denver-based Colorado Capital Bank. "When do banks decide they're actually going to be aggressively lending again?"

Outside the small-cap space, Bernstein found that financials provided the best risk/return in the S&P 500 over three- and five-year time horizons since 1990, even as the sector has deteriorated since the bank crisis began.

Hedge funds have been the most conservative strategy over the same time period, even though they brought a negative return for January 2009, while Treasurys had never lost money in that time.

The findings, indeed, could be seen as a reinforcement of a basic diversification and periodic reallocation strategy as the market looks to find its way out of the morass.

"What investors have forgotten is your asset allocation, while it should be long-term, needs to be reviewed periodically," Posada said. "We were complacent thinking that the market would just go up and up and up. I think we have to go back to that basic premise."